The review of India’s demonetisation

On 8 November 2016, the prime minister of India – Narendra Modi – announced the demonetisation of all ₹500 and ₹1,000 banknotes of the Mahatma Gandhi series. The government asserted that this would cut down the use of counterfeit cash, which funds illegal activities. As a result of this sudden announcement, there were sustained cash shortages causing a widespread slowdown in the Indian economy. The BSE SENSEX (Indian Stock Exchange) fell by a substantial 6 percent following the announcement. In addition, the people looking to exchange their old notes to the newly issued ₹500 and ₹2000 banknotes had to wait in lengthy lines. Absolute chaos. People argued that the demonetisation was poorly executed, and was linked to several riots in some places across India. However, by late August 2017, 99% of the banned currency was collected by banks. But how did the demonetisation affect the Indian economy?

Primarily, the most important success of the demonetisation has been that it has aided the Indian government in tracking black money. Large volumes of black money were kept secret by tax evaders and demonetisation has been effective to uncover the unaccounted cash. Estimates made by RBI indicated that more than 3 lakh crores (approximately 160,000 US Dollars) worth of black money has been deposited into bank accounts around India.

The large sums of black money in India, overall, had a net negative impact on the economy. It created a dual economy – “The existence of two separate economic sectors within one country, divided by different levels of development, technology, and different patterns of demand.” This unreported for an economy, where huge volumes of transactions were taking place, made it a struggle for the government to accurately analyse and create correct policies. Vital macroeconomic factors such as saving/income ratio and factor income levels were not precise. As a result, estimates of economic development reports in India, to some extent, were guesswork. Demonetisation helped: to limit the use of black money, to shrink the dual economy and to aid the government in formulating policies to benefit the economy.

Tax evasion was a huge problem all over India when black money existed. Tax evaders would not pay the appropriate income tax and would store their saved money in ₹500 and ₹1,000 banknotes. In 2016, Indian Express stated, “Data shows only 1% of the population pays income tax, over 5000 pay more than 1 crore.” However, when this new scheme was introduced, people had to disclose their income to the bank if they wanted to get the newly issued notes.

As expected by the government, a greater amount of the population paid taxes. A press release by CBDT (Central Board of direct taxes India) concluded that there was an increase in direct tax collection. “Collection of Advance Tax under Personal Income Tax (i.e. other than Corporate Tax) as on 05.08.2017 showed a growth of about 41.79% over the corresponding period in F.Y. 2016-2017.” “Collection of Self Assessment Tax under Personal Income Tax showed a growth of 34.25% over the corresponding period in F.Y. 2016-2017.” “About 9.1 million new taxpayers have been found, significantly expanding the taxpayer base,” a senior government functionary said on condition of anonymity.

Furthermore, with a decrease in tax evasion and a substantial increase in government tax revenue, the government is now able to spend a larger volume on improving merit goods such as education, healthcare, and infrastructure. In the 2017 budget, the Finance Minister announced an allocation of Rs 72,394 crore compared to Rs 68,963 crore for last year, which is 4.9 percent increase in the education budget. In theory, this should improve the quality of schools as better qualified teachers can be hired and the level of school resources can be enhanced. Students will learn better, perform higher leading to a greater number of youths going on to higher education. In the long run, unemployment rates will be lower as there will be a greater number of graduates actively seeking employment. Overall, this has a net positive effect on the economy and society.

However, Indian Express stated, “…if you consider inflation and GDP growth rate, education budget may come down to lower than the last year allocation (as % of GDP). Even after this increased allocation, education sector budget remains far from 6 percent of the GDP, which is desired by the education sector.” So time will only tell whether the increase in government spending on the education sector will be a useful investment.

Income inequality between the rich and poor in India has always been a pressing issue. Oxfam stated that “Richest 1% own 58% of total wealth in India.”

Supporting my earlier statement, the graph depicts the top 10% holding a much greater share of wealth than the bottom 10%. Almost 340 times more. The Indian government needed a countermeasure for this widening gap between classes; they thought the demonetisation would be that solution.

The poor in India typically holds asset portfolios of cash. By late August 2017, slightly more than 99 percent had returned to the banking system indicating that the poor weren’t harmed. The relatively poor – people who earn less than 40% of the average income – are generally the debtors, whilst the rich are the lenders. The demonetisation caused a decrease in inflation which meant the borrowers (the poor) were affected negatively. Transferring the relative wealth from the rich to the poor, widening the gap, demonstrating the demonetisation might have had an adverse effect on the economy.

However, with an increase in government expenditure in the economy the “per capita gross national disposable income of Rs 118,395 compared to the per capita gross domestic product of Rs 116,888, indicates a silver lining.” Even though the demonetisation didn’t have a direct effect on income equality, indirectly it had a spill-on effect. Improving the gap between the rich and poor.

Despite many benefits, the major disadvantage was the disruption to trade. It takes time for both consumers and suppliers to understand the new system which is in place. As a result, less economic activity was taking place causing the GDP to hit a 3 year low of 5.7%. In the short-run, GDP growth will slow down as there is an exogenous shock to the economy, but it will start to rise when people adapt.

In my opinion, the demonetization has had an initial impact of inconvenience, chaos, and disruption. However, as time progresses and people become more willing to abide by the new system, the economy will benefit and the Indian society will be a more prosperous nation. So did Modi make the right decision? Will India turn into a cashless society?

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Published by Aarkin Menocha

Aarkin is particularly interested in the link between financial economics and management. He has been involved in the entrepreneurship society, He's a keen cricketer and enjoys playing the guitar.
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